Chapter 9: Muniland’s long road to bankruptcy

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There has been so much talk in muniland about massive defaults, but so far there has been very little discussion about the actual mechanism of default and municipal bankruptcy. Public entities generally try everything before resorting to default or bankruptcy. The video above is an excellent primer on the many choices that can be made leading up to the end game.

In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant (condition) of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either unwilling or unable to pay their debt.

If a bond issuer doesn’t make a scheduled interest or principal payment on time (though there is usually a thirty-day grace period), then the bonds are considered in default.

The most common investor concern you hear in muniland is “willingness to pay.” One way to think of this would be if you managed the family budget and had to make a choice between feeding your children or paying your credit card bills. For a muniland bond issuer like a city, the comparable choice is between paying your bondholders before your employees.

There is also the larger and more complex process of a municipality going bankrupt. Public bankruptcies have their own section of the Bankruptcy Code called “Chapter 9.” Of course there are lots of oddities about public bankruptcies. Here is their purpose via Riski:

The purpose of chapter 9 is to provide a financially-distressed municipality protection from its creditors while it develops and negotiates a plan for adjusting its debts. Reorganization of the debts of a municipality is typically accomplished either by extending debt maturities, reducing the amount of principal or interest, or refinancing the debt by obtaining a new loan.

Although similar to other chapters in some respects, chapter 9 is significantly different in that there is no provision in the law for liquidation of the assets of the municipality and distribution of the proceeds to creditors. Such a liquidation or dissolution would undoubtedly violate the Tenth Amendment to the Constitution and the reservation to the states of sovereignty over their internal affairs.

And to further confuse the process 26 states either bar municipalities from going bankrupt or require permission from their legislature to do so. Here are the states where bankruptcy is not allowed via Bloomberg:

Alaska

Delaware

Georgia

Hawaii

Illinois

Indiana

Iowa

Kansas

Maine

Maryland

Massachusetts

Mississippi

Nevada

New Hampshire

New Mexico

North Dakota

Oregon

Rhode Island

South Dakota

Tennessee

Utah

Vermont

Virginia

West Virginia

Wisconsin

Wyoming

The biggest looming bankruptcy in the country is Jefferson County, Alabama. The county constructed a sewer system which far exceeded its budget estimates and left the system with an unsustainable debt. We will delve into this story another day. Bond defaults are very low this year, and there are only a handful of Chapter 9 bankruptcies. Nevertheless this is an important corner of muniland. We’ll touch on it again.

Author Profile

I’m Cate Long and I write about the retail fixed income markets including municipal bonds. My primary interest is creating tools and systems to help retail investors understand bond markets. I’ve worked for a number of years with industry standards organizations, regulators and Congress to help craft a more transparent and fair framework for investors to participate in the fixed income markets. I'm a guest contributor to Reuters.com. Any opinions expressed are mine alone.